In previous articles, I addressed two recent investment "fatigues" experienced by institutional investors: active vs. passive; and global vs. U.S. benchmarks. Now I'll tackle the third "fatigue"— hedge funds. Hedge funds have come under extreme criticism lately for their expensive fee structure, lack of performance and too much beta wrapped up in an alpha fee structure. It appears hedge funds are run more for the amusement of the hedge fund manager and less for the benefit of the hedge fund's clients. These are all legitimate concerns but I still believe there is value to be found in hedge fund land.
Let's take a step back in time. The surge in hedge fund investing began with the popping of the tech bubble in the early 2000s. Back then, the United States and every other developed equity market in the world suffered double-digit declines for three straight years from 2000-2002. Yet, during this market downturn, hedge funds actually lived up to their name — they hedged the market downturn. Over this period, the S&P 500 declined a total of 37.6% (-14.5% per year) while the HFRI Composite index of hedge funds increased 8.2% (2.67% per year).
Not surprisingly, the performance of hedge funds during this market downturn led to a surge of interest by institutional investors and, subsequently, the total assets under management in the hedge fund industry grew quickly. Total assets reached $3.005 trillion in 2016 from $118 billion in 1997. Perhaps even more revealing, Exhibit 1 shows the number of hedge funds also grew rapidly; hedge funds now exceed mutual funds in the U.S. — a demonstration of how quickly merchants set up "new rides" in hedge fund land.